The Culture of Speculation And The Failure of Financial Reform

Even as President Obama signs the mammoth financial regulation legislation designed to prevent another economy-busting meltdown, banks are already gaming the proposed regulations to generate new profits. For any business or nonprofit seeking to make serious changes in organization, the financial reform legislation is an abject lesson in what not to do. It is doomed to failure.

The reason is simple: Rules are not rituals. The 2,400 pages of proposed financial overhaul that will ultimately involve thousands of individual decisions on tens of thousands of rules will do little to curb what is really wrong with American finance — its culture of speculation. Over the past 30 years, gambling has become “gaming” and Main Street has rejected Max Weber’s Protestant Ethic for casinos, bridge, and the World Series of Poker. On Wall Street, the social function of banking has changed from promoting economic growth for the public good to generating large profits for the private sector. In the 40s, 50s, and 60s, banking was a government-protected, low-risk, low-profit utility that functioned as a catch-basin for savings that were transferred to businesses and families. Its return on equity (ROE) was 5%. Starting in the 70s, banking was transformed into a government-protected high-risk, high-profit business that functioned to generate income for partners and shareholders. Its ROE become 25%.

Banking changed from a culture of safety to a culture of speculation. It went on to capture an historically high percentage of profits generated in Corporate America, build a belief system that equated growth with risk and unregulated markets with efficiency, and take control of the government rule-making system through lobbying and political contributions. In short, high risk, once equated with sinfulness, was transformed into virtuousness. Where once saving was the dominant ritual in banking — a positive behavior strongly reinforced by the belief system — speculation replaced it. The culture of speculation was born.

Changing that culture by regulatory rule-making will not work. The process of rule-making in Washington is opaque, the negotiators are unequally paired in ability, and both sides share the same belief system. The best proof of this is the extraordinarily weak settlement the SEC worked out with Goldman Sachs of $550 million to settle federal claims of misleading investors in mortgage-back securities. The cultural symbolism of the settlement cannot be missed. The most central figure of the financial crisis receives a laughably small penalty from the government regulators. Lacking in credibility as well is the SEC’s permitting a statement by Goldman Sachs that it was a mistake, not a calculated decision, to fail to disclose that the loans in the CDO sold to investors had been selected by a third party hedge fund that specifically chose them to short. In effect, it winked at what many would perceive to be an obvious lie. The symbolic significance of this rule-making is to reinforce the culture of speculation, not reduce or replace it. I expect much the same result in the thousands of decisions that will be made by regulators over the course of the next year.

Changing culture is hard. Culture change is a brutal, transformative process. It is not simply a series of negotiated decisions based on an architecture of choices. Ask the handful of CEOs who succeeded in introducing a culture of innovation into their corporations — Sam Palmisano at IBM or A.G. Laffley at P&G, for example — and they will tell you that it has little to do with negotiating new rules but a lot to do with mandating new behaviors and new meanings. The most important way to change culture is for leaders to clearly define what is right and what is wrong and for policy-makers to erect boundaries around what is acceptable and what is not. Negotiation about rules of implementation is, in many ways, the least important part of the process. The last time the U.S. had to deal with the culture of speculation was in the 30s, when a half-century of boom and bust, excess, rising inequality, and social strain led to the Glass Steagall Act. Unlike the legislation passed by Congress this week, Glass Steagall was legislation that actually promoted culture change in finance. It did so by clearly delineating right from wrong, what was permissible and what was not. High-risk trading was separated from financial activities that were important to the economy and society as a whole — business loans, savings accounts and mortgages. And as such, only these activities received government support. These were boundaries, not rules up for negotiation. They were part of a distinct belief system built around publicly accepted social functions of finance — economic growth, not speculation. They were rituals.

Strangely enough, it has been 82-year old Paul Volcker, the former Federal Reserve chairman, who understands the cultural aspects of current speculation far better than the economic advisors surrounding President Obama. His proposed “Volcker Rule” would have cleaved high-risk from low-risk banking activities and helped restore a culture of saving to the U.S. The Volcker Rule would have reduced the profits, power and role of speculative finance in the economy, the political system, and most importantly, society as a whole. Alas, the culture of speculation defeated Volcker and his Rule.The U.S. needs a lot more Weber and a lot less poker to restore its position in the global economy once again.